The pros and cons of loan financing, compared to other investment channels

Real Value to Real People

I’ll start by saying that I believe in loans, because they fulfil real needs of real people, and as such, have an actual, tangible, quantifiable, real-world value.

With other investment, you usually buy some sort of asset and bet on its value to go up. Whether the asset is tangible (like oil or real estate) or intangible (like a stock or a currency), its value is always determined by market forces and speculation, making it difficult – if not impossible – to foresee. If the value remains the same, or goes down – you have only yourself to blame for making a bad bet.

Loans are grounded in reality: There’s nothing theoretic, hypothetical or speculative about them. They have a set value, which isn’t influenced by the borrower’s quarterly earning, or how much someone else is willing to pay for them. A loan isn’t a bet on the borrower’s willingness to repay. It’s a legally-binding agreement. In theory, no matter what happens, you are always eligible to receive what you have invested, plus interest.

That’s a nice theory. Now let’s look at the practicalities.

Loan Risk – Without Default Protection

You often hear about two categories of loans: “prime” and “subprime”. In reality, this is not a dichotomy but a spectrum.

At the top end are loans issued to the most financially-stable borrowers at very low interest rates, close to “prime” (the absolute lowest interest chargeable by banks). This market is controlled by banks and huge credit companies: Only they have enough money to lend, to make a significant profit out of such low interest levels.

Any borrower who is even slightly less financially-stable is considered a “subprime” borrower. Banks and large credit companies treat such borrowers with suspicion, and either deny their loan request or offer restrictive terms. This is the target audience of non-bank lenders and crowdfunding platforms. Each lender and platform focuses on different risk profiles, but either way, there is a real risk that borrowers fail to repay their loans.

Evaluating loan risk is difficult, especially when you don’t have all the details about the borrower or project, which is why platforms often offer some sort of risk rating. I also recommend looking at past loan performance.

Another important factor is the existence and value of collateral (a property or asset that was pledged by the borrower to the lender, which can be sold in order to recover the loan in case the borrower fails to repay).

Loan Risk – With Default Protection

On new-wave platforms, lending companies often offer protection against default in the form of “buyback guarantee”: If a loan runs very late, the lender buys it back from investors before it defaults. This eliminates default risk for investors, but shifts this risk onto lending companies.

These companies also tend to serve higher-risk borrowers, which are more likely to default. If too many loans are not repaid on time, lending companies may run into trouble upholding their buyback guarantee, or staying in business at all. Again, reviewing past loan performance is the best indication we have.

Platform and Loan Originator Risk

As we’ve just mentioned, too many default loans may lead a loan originator to bankruptcy. They may also lose their lending license, or decide to cease operations for some other reason. If the lending company stops being active, collecting money from borrowers becomes a lot tougher, and there’s a real risk of losing the entire investment in that lender.

There’s also a risk of the platform itself shutting down. This shouldn’t affect loan collection, but the procedure for keeping payments flowing to investors is not entirely clear, and would require appointing some sort of administrator.

Lastly, there’s the risk that the platform itself is somehow scamming investors. This happened with many P2P platforms in China, and more recently, with several Baltic platforms. It’s critically important to do due diligence before investing in any platform.

Regulation

Lending isn’t a new practice – it’s been around since the invention of money. Every country has regulations protecting both lenders and borrowers, and some countries have already adapted their policies for P2P loans specifically. It’s best to invest in countries where this practice is well-recognised by regulators.

Still, there’s always the chance that regulations would change in the future to further limit interest rates. This is good for the stability of the economy, but might push some lenders out of business. Not much we can do about it but stay informed.

Returns!

My number one reason for investing in loans is, of course, the high returns. New-wave European platforms currently offer returns in the realm of 10-15%, which is unparalleled by any other investment channel. However, these platforms are still pretty new, and no one knows whether these returns are sustainable for the long run.

Older platforms in other countries, which serve lower-risk borrowers, like Zopa in and LendingClub, offer returns in the realm of 4.5-8%. These are still very decent numbers, but their advantage over traditional investments is less clear.

As long as the European platforms maintain their crazy interests and good terms for investors, they remain the most attractive, in my view.

Liquidity

Liquidity is the ability to convert an investment back to cash when needed. Some platforms offer to buy back your loans (usually for a fee); others have a secondary market where you can try and sell your loans to other investors.

In comparison, stocks can be sold back immediately at any time, but this might result in losses. Also, I personally hate the lack of clear entry and exit points for stock investments: To free up money you always have to sell something. Loans have start and end dates, and are usually repaid on a monthly basis, so your money is naturally being freed up whenever you choose not to reinvest it. I find this to be a huge advantage in the context of financial independence – living off the income you earn through investments.

Compound Interest

Every time you do reinvest your earned interest, your portfolio grows by a tiny bit, which allows it to generate a tiny bit more profit with each passing month. This is called compound interest, and while it seems negligible at first, the effect becomes tremendous over time.

For example, 10% interest over 20 years would not generate 200% gain, as one might expect. Thanks to compound interest, the actual gain would be 633%! Albert Einstein called this “the eighth wonder of the world”, and it’s an important benefit of investing in loans. Here’s a compound interest calculator for you to play with.

There’s a similar way of calculating year-over-year return of stocks, called Compound Annual Growth Rate. For example, if a stock fund grew 200% in the past 20 years – its average annual growth was 10%, but its CAGR was only 5.65%. This is the right number to compare to loan investments. Here’s a CAGR calculator.

Taxation

On the flip side of compound interest, there’s taxation. In most countries, gains from stock investments are calculated when you sell the investment (or receive a dividend), and losses are taken into account to offset gains. With loans it’s more common to tax your earned interest at the end of each fiscal year – which slows down your accumulation of capital. Also, losses aren’t necessarily taken into account.

Bottom Line

I wouldn’t be investing in loans unless I thought it’s a viable, profitable and comfortable investment channel. However, I am constantly aware of the risks, and hope to see this industry become less edgy and more inhabited.

Until then we must keep our guard, track the performance of each platform and loan originator, and maintain wide diversification – among different platforms and loan originators, as well as other investment channels.

Legal notice: This post is not meant as investment counselling! I’m just a fellow investor sharing his personal experience and thoughts.